Bank Stocks Head Lower as Investors Look Ahead to Fed

NEW YORK ( TheStreet) -- Morgan Stanley ( MS) led bank stocks lower on Wednesday, with shares sliding more than 2% to close at $30.10.

The Dow Jones Industrial Average was down 0.8%, while the S&P 500 was 1.1% in the red and the NASDAQ Composite ended with a 1.4% decline, as investors shrugged off the good news of a budget deal in Washington and looked ahead to Thursday's retail sales report from the U.S. Census bureau and to a possible change in Federal Reserve stimulus policy next week.

The KBW Bank Index ( I:BKX) ended 1.4% lower to close at 66.48, with all 24 index components showing declines, except for BB&T Corp. ( BBT) of Winston-Salem, N.C., which was up 0.3% to close at $34.65. Big banks seeing 2% declines on Wednesday included Citigroup ( C), which closed at $50.71, and Bank of America ( BAC), which closed at $15.25.

Analysts continued to react to the release on Tuesday of final regulations to enforce the Volcker Rule, which bans banks that gather insured deposits from proprietary trading.

It took regulators over two years from the initial release of the Volcker regulations to finalize the rules, as the regulators struggled over the exceptions to the rules, to allow banks with brokerage operations to maintain sufficient inventories of securities to serve as market makers for their clients, while also allowing some hedging activity to protect the banks from losses on those securities. "Market hedges," covering against losses in entire asset classes were banned. After previously telling banks they would have to comply with Volcker by July 2015, the Federal Reserve threw the industry a bone, saying the new deadline for full compliance would be July 2015.

The outcome of the long wait for the final regulations to implement the Volcker Rule "is a codification of risk management practices that are the back-bone of current trading practices," Morgan Stanley analyst Betsy Graseck wrote in a note to clients on Wednesday. "Yes, incremental compliance requirements are new, but not a game changer. Banks will be able to engage in market making and have flexibility to manage risks," Graseck added.

Banks are effectively banned from investing in private equity funds, with slight exceptions that are so small as to be meaningless.

Looking ahead to next week, the Federal Open Market Committee next meets on Dec 17-18, and will release a statement on Federal Reserve policy on Dec. 18. As part of its "QE3" efforts to hold-down long-term interest rates and stimulate borrowing, the Fed has been making net purchases of long-term U.S. Treasury bonds and agency mortgage-backed securities at a net pace of $85 billion a month since September 2012. Considering last week's huge revision of estimated third-quarter U.S. gross domestic product growth to an annual rate of 3.6% from the previous estimate of 2.8%, and the improvement in the U.S. unemployment rate to 7% in November -- its lowest level in five years -- from 7.3% in October, some investors are expecting a "tapering" of bond purchases to be announced next week.

The curtailment of the Fed's bond-buying, sooner or later, will push up long-term interest rates, which typically spooks stock investors.

"We would be surprised by a QE tapering move at the December 17-18 FOMC meeting," wrote Goldman Sachs chief economist for the Americas Jan Hatzius in a Wednesday client note.

"Although employment growth has improved, core PCE inflation has fallen further and now stands 90bp below the Fed's target. Probably partly for this reason, only a minority of forecasters seem to expect tapering in December, which itself raises the hurdle for a move," he added.

Hatzius expects the Fed to taper bond purchases after the FOMC meets in March, although January is "possible."

Big Bank Chart

The KBW bank index has returned 30% this year, after returning 30% during 2012. The following chart shows the year-to-date price performance for Morgan Stanley, Bank of America and Citigroup:

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.